Why Some Landlords Choose to Create an LLC or Other Entities
When you first become a landlord, you may not have considered the type of business entity you need for your property management company. For some landlords, they simply fell into the rental market because they couldn't sell their house, wanted to move, and needed the rental income. Others simply aren't familiar with the benefits that comes from the right business entity, such as liability protection and tax exemptions.
This is a default business entity that you have when you file business taxes but you haven't established yourself as a LLC or another business structure. The only thing you need to establish this business structure is to file a DBA with your state. Landlords who are first starting out and don't know about the business entities available may file taxes as a sole proprietor prior to restructuring. The primary reason a sole proprietor is so bad for a landlord is a lack of a corporate veil. Instead of having protection from business liability, the sole proprietorship does not separate your personal and business assets.
A lack of a corporate veil is bad if something goes wrong at your rental properties and you get sued or incur a liability larger than your insurance company is willing to cover. Additionally, you do not get any tax benefits or additional ways to reduce your business tax liability, so you generally pay the highest tax rates as a sole proprietor. When you're renting out your real estate, you want to position yourself for the best tax advantage, so this business structure is not ideal for landlords.
A limited partnership, or LP, is typically used for someone who invests in rental properties but is not an active partner in managing the business. You act as a passive investor, so this is typically not a business structure used for landlords who are active in your business. While you do get liability protection so your personal assets are kept separate from your business liabilities, you do not get the same tax benefits as other structures. While some business tax benefits are realized, you miss out on depreciation because an LP is not supposed to be actively involved in business operations.
Limited Liability Company
A limited liability company, or LLC, is the structure many landlords turn to as their business entity. While you have to file slightly more paperwork to establish an LLC compared to a sole proprietorship, you get a lot out of the work without an overly complicated business structure. The LLC gives you limited liability with the protection of the corporate veil, as well as the ability to claim depreciation when filing business taxes. You can lower your overall tax liability with these advantages, as well as the ability to be taxed as a sole proprietor, S-corp or C-corp. A C-corp tax structure can be particularly advantageous for a landlord, as you don't get taxed at commercial tax rates but pass through the income to your personal return. Since you're paying yourself a salary and covering payroll taxes, you avoid a 15 percent dividends tax and the 14 percent self-employment tax, resulting in a lower overall rate.
An LLC is also remarkably flexible, giving you a strong foundation to build your property management business on. The operating agreement allows you to establish the business structure in the way that works best for you, and you also don't need to sit through annual meetings with everyone involved in the business unless you want to. All of these advantages add up to making the LLC the best business structure for your property management activities.
S- and C-Corporations
S- and C-corporations are not commonly used by many landlords, as an LLC is a less rigid business structure that can configure itself in a way to be taxed as an S-corp or a C-corp. The primary problems with these business entities are the required paperwork and activities associated with running the business. The filing fees required for establishing and maintaining a corporation are also expensive. You have to adhere to required corporate duties, such as conducting an annual meeting, and other responsibilities. The tax requirements for S-corps and C-corps are also quite complex compared to other entities, so unless you have a good reason to want to incorporate, it's better to pass up these options.
What Causes Personal Liability?
Even with a business entity in place, it's important to follow the laws and regulations revolving around keeping your corporate veil intact. One of the most common mistakes for landlords, especially when you're starting out, is to mix business and personal funds. It's essential to keep business income separate from your personal accounts, or else you could run the risk of personal liability. It's also important to properly follow any requirements in your operating agreement or the rules of a S- or C-corp so you are legally in compliance.
A business entity offers you the benefits of personal liability protection as well as many tax advantages. While several options are available, an LLC gives you the most flexibility and least hassle out of all available business entities for landlords.
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